The British economy defies explanation – but that’s no excuse for not doing the right thing

In the early days of the Coalition Government, the Office of Budget Responsibility predicted an early return to growth. They were wrong: the British economy flatlined instead. Earlier this year – in time for the Budget – the OBR downgraded its growth forecasts for 2013, halving what they’d predicted in last year’s Autumn Statement. Again, they were wrong – because, as we know, the British economy has since turned a corner.

Therefore, in its short life, the OBR has predicted high growth that turned out to be low, and low growth that turned out to be high. Still, as an economist could tell you, they were right on average.

One shouldn’t be too hard on the OBR, they were only following standard economic assumptions – which, as Simon Nixon demonstrates in an article for the Wall Street Journal, haven’t exactly stood the test of experience:

“The global financial crisis has challenged some of the economic profession’s most cherished assumptions. And no country has confounded the textbooks more than the curious case of the U.K.

“For five years, the British economy has persistently failed to behave as predicted by theory—and continues to do so with increasing evidence it is growing faster than almost any other major Western economy.”

Nixon shows how the economists got it wrong over and over again – on growth, on exports, on employment and on inflation. Oh and let’s not forget the contribution of the IMF to the world’s store of economic wisdom:

As recently as July, the International Monetary Fund was so gloomy about the U.K. that it was advising the government to loosen its deficit-reduction strategy. This month, it raised its 2013 growth forecast by half, to 1.4%.

All of which leads to a rather important question:

“How did the U.K. rapidly transform from laggard to leader right under the noses of the unsuspecting economics profession? And is this growth sustainable?

“…more policy makers and economists now accept that the most plausible explanation for the U.K.’s postcrisis underperformance and its recent outperformance lies in the workings of the financial system—something that barely features in standard macroeconomic models.”

The fact that these experts previously felt able to make predictions about the British economy without properly taking the financial system into account is something that will be of great interest to future economists – and, indeed, psychologists.

Anyway, here’s the new theory:

“Thanks to a broken banking system, the economy was unable to reallocate resources to productive parts of the economy, argues Kevin Daly, senior economist at Goldman Sachs. Healthy businesses were denied the credit they needed to expand.”

Simon Nixon concludes that while the economic profession was arguing “over Keynesian demand-side remedies, the main problem was one of supply—specifically the supply of finance.”

But what if the problem was actually one of demand – not the artificial demand created by unsustainable government giveaways – but demand for finance by solvent businesses looking to expand again?

As we’ve argued before on the Deep End, Britain’s business people aren’t impressed by the things that economic theorists seem to find so exciting. When deciding whether or not to invest in new equipment and personnel, it’s not last ditch fiscal punts that provide entrepreneurs with the necessary reassurance, nor new and exotic forms of monetary stimulus – but rather some sign that basic economic discipline is being restored.

It is essential that we now keep to this straight and narrow path. Having rightly rejected all the other dodgy short cuts to prosperity, George Osborne must also resist the temptation to artificially boost the supply of finance.